We Need Both A Strong And Weak Dollar For Stocks To Rally

That's right, we need the U.S. dollar to be BOTH strong AND weak at the same time for continued upside in equities. Much has been said about the greenback ever since the end of the Fed's QE3 program in late 2014. It was then all about king dollar leading up to the Fed's first (in a decade) rate hike in December 2015. Speculators kept piling in on the the freight express train that was the long dollar trade du jour, creating what has become one of the most crowded trades in modern history.

That debacle lasted for about a year, with markets getting abnormally volatile towards the end of last year. We've been ranting about how difficult it has been to hold a long term view on the dollar, be it on the consensus trade or the fundamentals. The myriad of dynamics at play makes this one of the trickiest environments to navigate.

But as we've made known to readers, we're not all that interested in currencies for directional trades as of now, rather, we see greater opportunities in the equity space. At least there is still some semblance of fundamental actors driving prices as opposed to the constant verbiage emanating from the central banking cartel we once trusted to prevent exactly this sort of financial pandemonium. Not only has their magic worn off, we have reason to believe that markets have grown to detest central banks because they have injected an almost unbearable amount of uncertainty amongst investors.

Despite the gravity that crude oil has gained over the last 4 months, crashing and surging at every timbre of action (or rather inaction) from OPEC, the U.S. dollar is still the number one lynchpin bonding different risk assets together in a symbiotic twirl.

It is also the dollar that we're most concerned about because to be honest, we haven't seen anyone being able to explain why the dollar might be stronger or weaker from where it is today. All we've heard are the ramblings of analysts pretending to know what the Fed themselves are unsure about. It has devolved to a point where it can be toxic holding a medium to long term position on the dollar (proxied by the DXY).

This conundrum is big, as we shall explain below.

Internals suggest a strong dollar is needed

The S&P 500 is heavily weighted on momentum stocks (the likes of Facebook, Amazon, Apple, Google). Momentum names are positively correlated to the dollar, so for the index to head higher, the pack has to be ubiquitously led by growth and momentum.

This chart visualizes the correlation between the internals of the SPX against the U.S. dollar. Broadly broken down into momentum (growth names such as FANGs) and value. First we note that because of the higher beta nature of momentum, this particular group carries a heavier weight in the index versus value as momentum names are typically higher capitalized (stocks such as AMZN, FB, GOOG, AAPL). Broadly speaking, momentum is implicitly long dollar, value is short, while the overall index is long. All this is true when the dollar is near historical highs. Again, the SPX is heavy on Internet names and momentum. Chart courtesy of JPM

This chart visualizes the correlation between the internals of the SPX against the U.S. dollar. Broadly broken down into momentum (growth names such as FANGs) and value. First we note that because of the higher beta nature of momentum, this particular group carries a heavier weight in the index versus value as momentum names are typically higher capitalized (stocks such as AMZN, FB, GOOG, AAPL). Broadly speaking, momentum is implicitly long dollar, value is short, while the overall index is long. All this is true when the dollar is near historical highs. Again, the SPX is heavy on Internet names and momentum.

Chart courtesy of JPM

Although there has been a resurgence in what is known in the parlance of quant finance as relative performance strategies (value tending to outperforming momentum in periods of higher volatility), we do not expect much more amplitude to this divergence from historical tendencies - that is for an index structured in such a way as the SPX, momentum should always lead the pack higher.

Another notable mention is that the SPX is also lightly biased to low volatility names, which tend to outperform when the dollar weakens and vice versa (utlities, industrials, consumer discretionary and the like) . In the current enrichment, this correlation has become somewhat murkier but still remains the core of this argument. A weak dollar will therefore likely not offset lag in momentum.

It's also crucial to understand that because most global markets are out of their respective bull markets, flows into equities have become dominantly the result of technical and quantitative strategies employed by sophisticated funds whose trading desks position according to volatility and are therefore inherently geared to chase momentum. On this vein, fundamentals tend to matter less. This also explains the recent (past 3-5 weeks) bifurcation in bond yields, credit spreads, equity returns, and the dollar.

In short, internals suggest a stronger dollar is imperative for positive equity returns.

Macro & fundamentals suggest the dollar has boxed us up

Here's where it starts to get fun. The carousel of active forces makes this confusing at best. But let's try to break it down and explain why we believe the dollar has trapped stock investors, especially passive investors with long positions in say an index fund.

As we've already explained in one of our Facebook posts earlier this week, the U.S. finds itself right smack in the middle of an earnings recession, and not a mild one by any measure. Fundamentally, for equities to continue up, the driver has to be organic - higher EPS. Much of the rally since 2014 has been on the back of multiple expansion. That is no longer happening.

"Is the U.S. in an earnings recession? We think so. Looking at GAAP earnings (the less shady accounting standard), S&P 500 EPS is expected to contract 8% in 1Q16 (YoY). That's a BIG contraction. How bad are the downward revisions? Very. At the end of 2015, EPS was only expected to grow by 0.3% in 1Q16. Fast forward 2 months, this forecast is now -8%. Also, the discrepancy between GAAP and non-GAPP earnings are huge! In fact, if we juxtapose both shades of P/E (of the S&P 500), the gap (pardon the pun) between GAAP and non-GAAP is the widest since the Great Recession and Financial Crisis on 2008. And it's not just limited to energy. Materials, industrials and the entire market is expected to see declines in profitability. With oil prices heading higher now, one can only imagine what havoc this will wreck on corporates. One last anecdote. JPM published a piece on Friday writing that in 80% of the observations across over 5 decades, a recession followed 2 consecutive quarters of earnings contraction. If indeed S&P 500 1Q16 earnings contracts (whatever the figure may be), then that marks the 4th consecutive quarter of declining EPS. This isn't an earnings recession, it's a depression!" Business Of Finance on Facebook, 7 March 2016

"Is the U.S. in an earnings recession? We think so. Looking at GAAP earnings (the less shady accounting standard), S&P 500 EPS is expected to contract 8% in 1Q16 (YoY). That's a BIG contraction.

How bad are the downward revisions? Very. At the end of 2015, EPS was only expected to grow by 0.3% in 1Q16. Fast forward 2 months, this forecast is now -8%.

Also, the discrepancy between GAAP and non-GAPP earnings are huge! In fact, if we juxtapose both shades of P/E (of the S&P 500), the gap (pardon the pun) between GAAP and non-GAAP is the widest since the Great Recession and Financial Crisis on 2008.

And it's not just limited to energy. Materials, industrials and the entire market is expected to see declines in profitability. With oil prices heading higher now, one can only imagine what havoc this will wreck on corporates.

One last anecdote. JPM published a piece on Friday writing that in 80% of the observations across over 5 decades, a recession followed 2 consecutive quarters of earnings contraction. If indeed S&P 500 1Q16 earnings contracts (whatever the figure may be), then that marks the 4th consecutive quarter of declining EPS. This isn't an earnings recession, it's a depression!"

Business Of Finance on Facebook, 7 March 2016

A weaker dollar would be extremely beneficial to a large majority of American firms, especially for multinationals and export driven firms (energy, manufacturing). Margins have already been severely impacted by the dollar being near historical highs (trade weighted). While cost of production has admittedly gone down for many, this less than offsets the carnage seen in energy, where a strong dollar has been to the utter chargin of crude and gas prices.

Hence, a strong dollar hurts SPX profitability in a huge way. Alluding to the law of diminishing returns, a sudden capitulation in the long dollar trade (lower DXY) would likely see guidance being revised higher come 1Q16, a sound basis for higher prices.

On a macro perspective, a strong dollar would be tantamount to a Fed on a tightening policy. While the Fed technically is already tightening by leveling off its SOMA and having hiked rates by 25bp on December last year, the market works on expectations of what the Fed may do in the future.

Spot any consistent correlation between the dollar index (DXY) and the S&P 500 (SPX)? Well no, there isn't any consistent correlation. According to quantitative analysis by JP Morgan, there currently exists a positive correlation of about 0.3 between the DXY and the SPX.  However, as this chart depicts, there are phases where this correlation is detectable even to the naked eye, phases where there is very low correlation, and phases of negative correlation. The degree of correlation also depends on the rolling average applied. A 5-day rolling average would generate results of high negatives, while a 30-day rolling average would most mask short term divergences from the mean. In the longer run, it is reasonable to expect correlations to be positive. Chart by Business Of Finance

Spot any consistent correlation between the dollar index (DXY) and the S&P 500 (SPX)? Well no, there isn't any consistent correlation. According to quantitative analysis by JP Morgan, there currently exists a positive correlation of about 0.3 between the DXY and the SPX.  However, as this chart depicts, there are phases where this correlation is detectable even to the naked eye, phases where there is very low correlation, and phases of negative correlation. The degree of correlation also depends on the rolling average applied. A 5-day rolling average would generate results of high negatives, while a 30-day rolling average would most mask short term divergences from the mean. In the longer run, it is reasonable to expect correlations to be positive.

Chart by Business Of Finance

As far as we can tell, the market doesn't expect the Fed to tighten further. In fact, we have explained  (on our Facebook page) that Eurodollar options are (for 4 months now) pricing in NIRP (negative rates) by end 2016. There is a good amount of uncertainty if we look at things through this lens.

A weak dollar on the other hand implies a Fed on hold, bonds are likely going to be bid and equities should see positive short to medium term returns on a global re-risking trade. How likely is this scenario? We don't know and we don't bother.

SPX correlation to oil price has also been strongly positive as of late. This is unorthodox to historical tendencies, but as we've mentioned earlier, the environment we're in currently is far from what may be deemed as typical.

Concluding

Our point is that a weak dollar is very much welcomed by the market, but technical forces suggest that should the dollar weaken by any substantial amount, SPX will likely be dragged lower by momentum names.

It's likely going to be a tug of war between these forces we've highlighted in this piece. Again, we make no predictions as to direction. We do however expect this conundrum to continue until a novel catalyst emerges that alters the way market participants trade and position. What this novel catalyst is, we don't know.